What is a spread in FOREX Trading?
Every market has a spread and so does forex. Spread simply refers to the price difference between an underlying asset and where a trader can purchase it or sell it. This spread is commonly known by traders who are familiar with equities.
Below we can see an example of the forex spread being calculated for the EUR/USD. We will first find the buy price at 1.13398, then subtract the sell prices of 1.3404. After this, we get a reading of 0.00006. Remember that traders should keep in mind that the EUR/USD pip value is identified as the fourth digit after decimal. This makes the spread of 0.6 pips.
We now know how to calculate spread in pips. Let's examine the actual cost for traders.
HOW TO CALEALE THE FOREX SPREADS AND COSTS
Remember that spreads are simply the ask price less (minus the bid price) of a currency pair. In our example, 1.13404-1.13398 = 0.06 pips.
We can buy EUR/USD at 1.13404 at the moment and close the transaction at 1.13398. This means that traders would be charged 0.6 pip spread once the trade is closed.
We will need to divide this total spread cost by the pip cost and take into account the total number of lots that were traded. A 10k EUR/USD lot would cost you 0.00006 (0.6pips) times 10,000 (10k lots) = $0.6. Spread costs for a standard lot (100,000. units of currency) would be 0.00006pips (6.6%) x 100,000 (1 standard lots) = $6.
If your account is denominated in another currency, like GBP, you would have to convert it to US Dollars.
UNDERSTANDING A HIGH AND LOW SPREAD
It is important to remember that FX spreads can change throughout the day. They can range from a high spread to a low spread.
The spread can be affected by many factors, such as volatility and liquidity. Some currency pairs, such as emerging market currency pairs have a wider spread than major currencies pairs. Major currency pairs trade at higher volumes than emerging market currencies. This leads to lower spreads in normal conditions.
Additionally, it's well known that liquidity can dry up and spreads can widen in the lead up to major news events and in between trading sessions.
Spread is high
Spreads are high prices that indicate a significant difference between the ask and bid price. The spread for emerging market currency pairs is generally higher than major currency pairs.
A spread that is higher than the norm can indicate one of two things: high volatility in a market or low liquidity due out-of-hours trades. Before news events, or during big shock (Brexit, US Elections), spreads can widen greatly.
Spread is low
Spreads that are low indicate that there is only a slight difference between the ask and bid prices. It is preferable to trade when spreads are low like during the major forex sessions. A low spread generally indicates that volatility is low and liquidity is high.
KEEP AN EYE OUT FOR CHANGES IN THE SPREAD
Market uncertainty is notoriously high during news. Releases on the economic calendar happen sporadically and depending if expectations are met or not, can cause prices to fluctuate rapidly. Large liquidity providers don't know what the outcome of news events will be before they are released, just like retail traders. They seek to mitigate some of the risk by increasing spreads.
Margin calls can be caused by spreads
If you are currently holding a position and the spread widens dramatically, you may be stopped out of your position or receive a margin call. Limiting leverage in your account is the best way to protect yourself from widening spreads. Sometimes it is a good idea to keep a trade open during spread-widening periods until the spread narrows.
For more tips on how to successfully navigate the forex spread, take a look at our recommended forex spread trading strategies.
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